Friday, September 2, 2016

Kocherlakota on cash

Narayana Kocherlakota, formerly the head of the Federal Reserve Bank of Minneapolis and now a prolific economics blogger, penned a recent article on the abolition of cash. Kocherlakota makes the point that if you don't like government meddling in the proper functioning of free markets, then you shouldn't be a big fan of central bank-issued banknotes. For markets to clear, it may be occasionally necessary for nominal interest rates to fall well below zero. Cash sets a lower limit to interest rates, thus preventing this rebalancing from happening.

I pretty much agree with Kocherlakota's framing of the point. In fact, it's an angle I've taken before, both here and in A Libertarian Case for Abolishing Cash. Yes, my libertarian and other free-marketer readers, you didn't misread that. There is a decent case for removing banknotes that is entirely consistent with libertarian principles. If you think usury laws are distortionary because they impose a ceiling on interest rates—and there are some famous libertarians who have railed against usury—then an appeal to symmetry says that you should be equally furious about the artificial, and damaging, interest rate floor set by cash.

Scott Sumner steps up to the plate and defends cash here. He brings up some good points, but I'm going to focus on his last one. Scott says that a cashless economy would create a "giant panopticon" where the state knows everything about you. I quite like Nick Rowe's response in which he welcomes Scott to the Margaret Atwood Club for the Preservation of Currency. In Atwood's dystopian Handmaid's Tale, a theocratic government named the Republic of Gilead has taken away many of the rights that women currently enjoy. One of the tools the Republic uses to control women is a ban on cash, all transactions now being routed digitally through something called the Compubank:

I agree that we don't want to abolish cash if it is only going to lead to Atwood's Compubank. But Scott misses the fact that even though Kocherlakota wants the government to exit the cash business, he simultaneously wants fintech companies to take up the mantle of anonymity services provider. Like Sumner, Kocherlakota doesn't seem to want a Compubank.

For instance, in a recent presentation entitled The Zero Lower Bound and Anonymity: A Monetary Mystery Tour, Kocherlakota highlights the potential for cryptocoins Zcash and Monero to substitute for central bank cash. Unlike bitcoin, these cryptocoins provide full anonymity rather than just pseudonymity. If you want to learn more about Zcash, I just listened to a great podcast with Zcash's Zooko Wilcox-O'Hearn here. As for Monero, Bloomberg recently covered its spectacular rise in price.

As Monero illustrates, cryptocoins are incredibly volatile. Is anonymity too important of a good to be outsourced to assets that behave like penny stocks? I'm not sure. And as Nick Rowe points out, the concurrent circulation of deposits (pegged to central bank money) and anonymity-providing cryptocoins would create havoc with the traditional way of accounting for prices. Retailers would probably still set prices in terms of central bank money but anyone wanting to purchase something anonymously would have to engage in an inconvenient ritual of exchange rate conversion prior to consummating the deal. Perhaps these are simply the true costs of enjoying anonymity?

Kocherlakota doesn't mention it explicitly, but should cash be abolished in order to remove the lower bound to interest rates, a potential replacement would be a new central bank-issued emoney, either Fedcoin or what Dave Birch has dubbed FedPesa. A good example of a Fedcoin-in-the-works comes from the People's Bank of China, which vice governor Fan Yifei expects to "gradually replace paper money." As for Birch's FedPesa, a real life example of this is provided by Ecuador's Dinero electrónico, a mobile money scheme maintained by the Central Bank of Ecuador (CBE) for use by the public.

Should a government decide to abolish cash and implement a central bank emoney scheme in its place, it would be possible to set negative interest rates on these tokens while at the same time promising to provide both stability and anonymity. One wonders how credible the latter promise would be. The CBE requires that citizens provide national identity card before opening accounts. And consider that the PBoC's potential cyptocoin will be designed to provide "controlled anonymity," whatever that means. Unless significant safeguards are set, it's hard not to worry that a potential Atwood-style Compubank is waiting in the wings.

An alternative way to coordinate a smooth government exit from the cash business is Bill Woolsey's idea of allowing private banks to step into the role of providing banknotes. In this scenario, the likes of HSBC, Bank of America, Wells Fargo, Deutsche Bank, and Royal Bank of Canada would become sole providers of circulating banknotes. Wouldn't this simply re-establish the zero lower bound? Not necessarily. As I wrote back in 2013, the moment a central bank sets deeply negative interest rates, private banks will face huge incentives to either 1. get out of the business of cash or 2. stay in the game while modifying arrangements, the effect being that the zero lower bound is quickly ripped apart.

The provision of anonymity services via the issuance of private banknotes has some advantages over cryptocoins like Zcash. Since they'd be pegged to central bank money, private banknotes would provide 'fixed-price' anonymity. Nor would the public have to constantly do exchange rate conversions between one currency type or the other. On the other hand, Zcash payments can be made instantaneously over long distances; you just can't do that with banknotes. And of course, there's also the stablecoin dream, i.e. the possibility that private cryptocoins like Zcash might themselves be stabilized by pegging them to central bank cash, as Will Luther describes here (for a more skeptical take, read R3's Kathleen B here)

Because of what he calls "over-issue" problems, Kocherlakota is more confident in the prospects for cryptocoins than private banknotes. I'm not so worried. The voluminous free-banking literature developed by people like George Selgin, Larry White, and Kevin Dowd teaches us that as long as silly regulations are avoided, the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded. Don't look to the so-called U.S. Wildcat banking era for proof. During that era, note-issuing banks were too encumbered by strict laws against branch banking and cumbersome backing rules to effectively supply notes, as Selgin points out here. Rather, the Scottish and Canadian banking systems of the 1800s provide evidence that banks can responsibly issue paper money.

Wouldn't the private provision of banknotes require the passing of new laws? Funny enough, U.S. commercial banks can already issue their own banknotes. In a fascinating 2001 article, Kurt Schuler points out that federally-chartered banks have been free to issue notes since 1994 when restrictions on note issuance by national banks was repealed as obsolete by the Community Development Banking and Financial Institutions Act. So the floodgates are open, in the U.S. at least, although as of yet no bank has taken the lead.

If governments are going to remove the zero lower bound by getting out of the business of providing anonymous payments, I say let a thousand flowers bloom. If the void is to be filled, don't put up any impediments to the creation of anonymity-providing fintech options like Zcash, but likewise don't prevent old fashioned banks from getting into the now-vacated banknote game either. Let the market decide which anonymity product they prefer... and celebrate the fact that the government's artificial floor to interest rates has been dismantled.

P.S. It would be remiss of me to omit pointing out that there are sound ways to dismantle the zero lower bound without removing cash, Miles Kimball's plan being one of them.

"the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded."

But convertibility can only be maintained if the issuing bank has enough assets to buy back 100% of its notes at par. As soon as people think the bank has only 99% backing, a run will start, and maintaining convertibility only hastens the run. If the same bank suspends convertibility, then people will value its notes at 99% of par.

JP, eliminating half of the monetary base is a huge tightening of monetary policy by the central bank. This will slow nominal GDP, damage employment, and lower bond yields.

Negative interest rates will be a consequence of Kocherlakota's constraining currency in the monetary base.

Want to exit the zero rate bound? Promise to print currency. Keep at it until nominal GDP increases to 6% year-over-year.

Worried, as you do, about creating the demand for currency? Abolish the quasi-criminal cash usage limits in the banking system instead -- or raise them to $1 million or such, not $10,000. It's the easiest monetary policy option on the table (if easier policy is indeed the goal).

"JP, eliminating half of the monetary base is a huge tightening of monetary policy by the central bank. This will slow nominal GDP, damage employment, and lower bond yields."

The idea is to have the private sector fill in, or even central banks to issue emoney to the public. One gets out of the tub, the other gets in.

"Promise to print currency. Keep at it until nominal GDP increases to 6% year-over-year."

Central banks can only passively respond to the public's demand for paper currency, they can't initiate an expansion in the supply. When they use "printing" to execute expansionary monetary policy, they do by creating electronic deposits. Even if cash is abolished, a central banker can still loosen policy.

Negative interest rates pretty much do the same thing as creating electronic deposits, so I don't see why there is much controversy over them.

"Eliminate currency, and you not only destroy individual rights for the benefit of an Orwellian banking panopticon..."

I dealt with the Orwellian critique in my post. Go read the 3rd and 4th paragraphs.

"Abolish the quasi-criminal cash usage limits in the banking system instead -- or raise them to $1 million or such, not $10,000."

JP, I don't buy the tubs. Private sector currency is counterparty inferior, and central bank emoney is a wasting negative yielding asset. So you take away a superior asset, and fill the tub with inferior assets? That's a rip-off. Why is this needed again?

Negative interest rates are a symptom of overly-tight monetary policies. If you assume a need for negative rates, you've already assumed that NGDP growth is feeble, and that monetary policy is brutally tight. Rates are an outome, a price -- not a policy.

And JP, how can you have *public demand for paper currency* when cash is treated as quasi-criminal?! Demand is legally constrained at $10,000, and practically constrained at much lower levels.

Remove or raise bank limits on withdrawing currency, and you just might understand actual free-market public demand for currency. Until then, please don't bother talking about currency demand.

I'm still waiting to hear why printing currency -- which circulates in NGDP -- has no effect on monetary policy. Interest-paying electronic bank reserves do not circulate in NGDP, you understand of course. Reserves are barely part of the monetary base any more.

"how can you have *public demand for paper currency* when cash is treated as quasi-criminal?! Demand is legally constrained at $10,000, and practically constrained at much lower levels."

My parents have had to withdraw cash above the $10,000 limit multiple times and have never run into problems.

In any case, the main point is that regular people hold on average around $100 in their wallets. If the average demand to hold cash rises to, say, $200, that demand will be immediately accommodated. Society as a whole will have their needs met.

"I'm still waiting to hear why printing currency -- which circulates in NGDP -- has no effect on monetary policy. "

Again, central banks don't use currency printing as a monetary policy tool. Currency is drawn out of the central bank, which passively accommodate that demand. Central banks use interest rates as their way to influence NGDP.

Central bank e-money may easily become negative yielding, i.e. a wasting asset (although how stealing away disposable interest income from savers somehow "stimulates" is frankly boggling. As in the US 1970s, high interest rates are a sign that monetary policy has been loose -- not tight.)

...and the bank filed a "suspicious transaction report" on your parents. Please don't argue by anecdote in any case.

And, no, JP, central banks use the monetary base to influence NGDP. Interest rates are a price outcome of the monetary base: rates are nothing but the price of debt, not some magic NGDP creator.

I have to ask, JP, are low rates a sign that monetary policy has been tight in your world? How again did Zimbabwe gain such high rates of NGDP growth? What were ZIM interest rates, then?